INFLATION AND UNEMPLOYMENT IN ICELAND IN THE LIGHT OF NATURAL-RATE THEORY

Transcription

1 CENTRAL BANK OF ICELAND WORKING PAPERS No. 17 INFLATION AND UNEMPLOYMENT IN ICELAND IN THE LIGHT OF NATURAL-RATE THEORY by Gylfi Zoega March 22 CENTRAL BANK OF ICELAND Economics Deparmen

2 Cenral Bank of Iceland Working Papers are published by he Economics Deparmen of he Cenral Bank of Iceland. The views expressed in hem are hose of heir auhors and no necessarily he views of he Cenral Bank of Iceland. Also available on he Cenral Bank of Iceland World Wide Web sie (hp:// All righs reserved. May be reproduced or ranslaed provided he source is saed. ISSN:

3 Inflaion and Unemploymen in Iceland in he Ligh of Naural-Rae Theory by Gylfi Zoega * Deparmen of Economics, Birkbeck College Universiy of London, 7-15 Gresse Sree, London W1P 2LL Absrac This paper uses Icelandic daa o assess sandard mehods for esimaing he naural rae of unemploymen. Surprisingly, esimaing he pah of he naural rae of unemploymen for he period produces a naural-rae pah ha mirrors he pah aken by acual unemploymen. The paper goes on o show ha his resul is misleading for hree reasons: Firs, he unemploymen spells of low-income workers appear o have been parly volunary and heir unemploymen herefore did no exer much downward pressure on wages and prices, nor did heir reemploymen a he end of he 199s hreaen price sabiliy. Second, he influx of foreign workers during he recen boom reduced inflaionary pressures. Taken ogeher, he wo effecs caused he effecive labour force o adjus o changes in he demand for labour, hence obscuring he relaionship beween inflaion and unemploymen over he cycle. In addiion, here is an asymmery in any effec unemploymen may have on inflaion in ha wages and prices exhibi downward rigidiy a low inflaion raes. As a resul, esimaing he level of he naural rae of unemploymen using daa on inflaion and unemploymen ends o be misleading a low inflaion raes. * This paper is wrien in collaboraion and associaion wih he Deparmen of Economics a he Cenral Bank of Iceland. Thanks go o Gudmundur Gudmundsson, Már Gudmundsson, Thórarinn G. Póursson and Arnór Sighvasson for heir many commens. Deparmen of Economics, Birkbeck College, Universiy of London, 7-15 Gresse Sree, London W1P 2LL.

4 Inroducion The objecive of his paper is o analyse price- and wage dynamics in Iceland in ligh of he heory of he naural rae of unemploymen. Iceland was hi by rising unemploymen a he beginning of he 199s, as were he oher Scandinavian counries. Unemploymen peaked in 1995 bu has since fallen back o levels ha have pu price sabiliy a risk. Inflaion seemed insensiive o changes in unemploymen for mos of he 199s, alhough i has risen in he las few quarers. For his reason, aemps o esimae he pah of he naural rae of unemploymen in he 199s have someimes generaed pahs ha mirror he one aken by he acual unemploymen rae iself (see Gudmundsson and Zoega, 1997; Cenral Bank of Iceland, 21, page 6). I is he objecive of his paper o re-evaluae he evidence and o propose some possible explanaions for hese surprising resuls. A number of OECD counries have experienced non-inflaionary expansions in recen years. 1 Numerous explanaions have been offered for he apparen disappearance of price inflaion. There is he hesis of Akerlof e al. (1996, 2) ha pas and expeced inflaion sops being relevan in wage- and price seing when i reaches very low levels. This may preven an inflaionary spiral from emerging because pas inflaion does no or a leas no compleely feed ino curren inflaion. Oher auhors have ried o explain why he naural rae of unemploymen may have fallen in recen years. Demographic changes could possibly consiue such an explanaion when he wihin-group unemploymen raes differ across he sexes, age groups or educaion groups: when a high-unemploymen demographic group shrinks in relaive numbers, he aggregae unemploymen rae is likely o fall (Shimer, 1999). There is also he possibiliy ha he wihin-group unemploymen raes have fallen across he board (Phelps and Zoega, 1997 and 1998, amongs ohers). A fall in he wihin-group raes could be caused by more rapid echnical progress and lower real ineres raes ha make firms sep up hiring, lowering he naural rae of unemploymen for all demographic groups. 2 Finally, wage norms may ake ime o cach up wih rising raes of produciviy growh. A rise in he rae of echnical progress may hen gradually reduce he marginal cos of labour because wages fail o keep up wih rising produciviy (Ball, 2). 1 These include he Unied Saes, he U.K., he Neherlands, Ausralia and New Zealand o name a few examples. 1

5 Iceland provides a good esing ground for hese, and oher, explanaions in ligh of is small size and good official saisics. In addiion, several developmens have aken place in Iceland ha may help explain he unil quie recenly dorman inflaion and have no been ouched on in he lieraure so far. We sar in Secion I by describing he recen experience in he Icelandic labour marke. We hen spell ou a simple model of equilibrium in he labour marke, use i o derive a mehod o esimae he naural rae of unemploymen and apply i o Icelandic daa. In Secion III we discuss and compare some of he possible explanaions for he recen developmens. Secion IV concludes. I. From bus o boom Labour demand rebounded in he second half of he 199s. Following a depressed labour marke in firms sared o repor vacancies, hiring acceleraed and unemploymen fell o an average rae of 1.3% in 2. The figure below has he number of vacancies. Figure 1. Number of repored vacancies, (April and Sep./Oc.) Source: Biannual survey by he Naional Economic Insiue. Despie a pickup in he number of vacancies in , heir number did no rival hose seen in he las expansionary period in he mid 198s. However, he fall in he unemploymen rae was subsanial as shown in he figure below, which also plos he non-employmen rae (non-employmen as a raio o he working-age populaion). 2 See also Phelps and Zoega (21), Fioussi, Jesaz, Phelps and Zoega (2), Phelps (1994), Pissarides (2). 2

6 Figure 2. The unemploymen rae and he non-employmen-o-populaion raio. All workers. 45 nonemploymen rae (%) 4 6 unemploymen rae (%) nonemploymen unemploymen Noe ha despie he impressive recovery of he unemploymen rae, he decline in non-employmen was much smaller in comparison. I is helpful o separae men and women before drawing any furher conclusions. The figures below have unemploymen and non-employmen by sex. Figure 3. The unemploymen rae and he non-employmen-o-populaion raio, men and women Men 2 nonemploymen rae (%) nonemploymen 5 unemploymen rae (%) unemploymen Women 8 nonemploymen rae (%) unemploymen 8 unemploymen rae (%) nonemploymen

7 Boh he unemploymen rae of men and heir non-employmen rae peaked in As shown in Table 1, he former rose by 6.2% from 199 o 1995 and unemploymen by 2.7%. In conras, non-employmen among women rose by only 2% over he same period while unemploymen rose by 3.9%. Turning o he recen expansion, he unemploymen and non-employmen raes fell slighly more in he case of women 3.5% versus 2.8% for unemploymen and 4.6% versus 3.3% for non-employmen. Table 1. Changes in unemploymen and he employmen-o-populaion raio Years Sex u (%) Non-employmen Male 2.7% 6.2% Female 3.9% 2.% Male -2.8% -3.3% Female -3.5% -4.6% The ne effec of hese wo episodes was o increase he rae of non-employmen among men and he unemploymen rae among women. This, ogeher wih he relaively low vacancy rae, suggess ha he unemploymen rae in 1999 may have oversaed he ighness of he labour-marke pressure. In paricular, one would conclude ha hese were no as srong as in he mid-o-lae 198s. Tables 2 and 3 show ha during he period, he increase in he number of working-age men wihou a job was close o 6, men of which 2,9 regisered as unemployed he rise in unemploymen accouned for abou 1/3 of he oal rise in non-employmen. For women, he increase in he number of non-employed was smaller, or 3,127, while he increase in he number of unemployed women was equal o 2,25, which is higher han for men. We can conclude ha while more women became unemployed, he increase in oal non-employmen was higher for men. In conras, he expansion appears o have benefied boh sexes equally. 4

8 Table 2. Changes in he working-age populaion, he number of people unemployed and he number non-employed, Years Sex Working-age populaion Number employed Number nonemployed Male 4,47-1,919 5,966 Female 3, ,127 Male 3,819 6,11-2,342 Female 4,146 6,639-2,493 Table 3. Changes in he labour force, he number of employed and he number of unemployed workers, Years Sex Labour force Number employed Number unemployed Male 9-1,919 2,9 Female 2, ,25 Male 4,133 6,11-2,28 Female 4,812 6,639-1,827 Noe also ha while he number of employed men fell by close o 2, beween 199 and 1996, he number of employed women rose. The oal number of los jobs equals he difference beween he wo, only 1,174! The bulk of he increase of around 9, in non-employmen and 4, in unemploymen is hus accouned for by an increase in working-age populaion and he labour force. The recen labour-marke expansion can be furher described by drawing on he socalled Beveridge curve (see Blanchard and Diamond, 1989) ha plos he relaionship beween vacancies and unemploymen (boh as a raio o he labour force) shown below. One would expec hese o be negaively relaed over he business cycle rising unemploymen and a falling number of vacancies should go hand in hand while shifs are caused by changes in he level of fricion in he maching of jobs and unemployed workers. Unemploymen has fallen since he beginning of 1997 while he vacancy rae (now defined as a raio o he labour force) increased bu only slighly. 5

9 Figure 4. The Beveridge curve, vacancy rae (%) 4 85-apr 2 98-sep 99-sep 97-sep 99-apr 99-jan 98-apr 98-jan 97-apr 97-jan unemploymen rae (%) Noe ha he vacancy rae a he end of 1999 was nowhere near he raes experienced in he mid 198s, which were around 3%, while unemploymen was approaching is earlier level. This suggess ha labour-marke pressures were less serious han he unemploymen rae would imply. The figure below shows wage inflaion and price inflaion, measured by boh he consumer-price index and he GDP deflaor. Figure 5. Price- and wage inflaion in Iceland 1 % CPI Wages GDP Noice he increase in wage inflaion in However, price inflaion remained lower by year 2. The resuling change in real wages in he pas en years follows. 6

10 Table 5. Real-wage growh in recen years Year % Year % A key quesion is wheher he expansion brough he unemploymen rae dangerously low, i.e. if he acual rae was lower owards he end of he expansion han he one compaible wih sable prices. Some pas esimaes have ended o pu he level of he naural rae considerably above he curren level of 2%. 3 These apply sandard mehods o be reviewed below and esimae he naural rae based on he sensiiviy of inflaion (or raher he change in inflaion) o he rae of unemploymen. Noe ha in 2 he rae of wage and price inflaion increased. The recen wage growh is shared by mos occupaions. Table 6 shows he proporional change in nominal wages from he las quarer of 1999 o he las quarer of 2. The average increase in real wages was 3.5% over his period. Table 6. Growh of nominal wages, various professions, % (Las quarer of 1999 o las quarer of 2) Manual labour 9.4 Office workers 7.9 Specialis labour 8.9 Technicians 8.1 Crafsmen 8.6 Professionals 9.2 Services 1.2 Source: Kjararannsóknarnefnd, March This applies o he OECD and a paper by his auhor using similar mehodology (Bjorn Runar Gudmundsson and Gylfi Zoega, 1997). However, he Cenral Bank of Iceland s esimaes have been somewha lower. 7

11 Alhough he wage increases are somewha larger on average in he service secor, here is no clear endency for any occupaion o lag seriously behind. 4 Taken a face value, hese numbers sugges rising wage inflaion. Few accurae measures of oal facor produciviy growh exis for Iceland (see, however, Cenral Bank of Iceland, 2). However, by looking a he share of labour and capial in naional income, we can infer ha wages grew faser han produciviy in recen years. This finding is of significance beyond he recen inflaion acceleraion and appears o be an ineresing characerisic of he Icelandic economy. Figures 6 and 7 below show he wo facor shares superimposed on he unemploymen rae. 5 Figure 6. The share of labour in naional income and he unemploymen rae u n e m p l. % u n e m p lo y m e n l a b o u r s h a r e la b o u r s h a re % Figure 7. The share of capial in naional income and he unemploymen rae unempl. % 6 capial share capial share % unemploymen The daa also reveal ha he average wage growh is slighly higher for women (9.4%) han men (8.5%) and higher for people living in Reykjavik (9.5%) han on he counryside (8.1%). 5 Noe ha he share of profis does no include depreciaion. 8

12 Ineresingly, here appears an inverse relaionship beween unemploymen and he share of labour (see also Cenral Bank of Iceland, 2, page 7). Unemploymen rose when he labour share fell in and came down in when labour s share rose. The fall in labour s share in he firs par of he 199s wen ogeher wih rising unemploymen and he recen rise in he share coincides wih falling unemploymen. We now sep back and describe he deerminaion of labour-marke equilibrium ha is, he naural rae and use i o derive and describe a mehod used o calculae he naural rae of unemploymen before reurning o he Icelandic saga. II. Theory behind he naural rae Equilibrium in he labour marke is deermined by he ineracion of employers and employees. In one formulaion, employers aemp o se prices high relaive o wages and employees aemp o se wages high relaive o prices. In equilibrium, he wo demands are reconciled, i.e. he equilibrium unemploymen rae is such ha workers and firms demands are consisen. This is he bale of he mark-ups emphasised by Layard and Nickell (1986). Alernaively, one can envisage employers seing wages o affec incenives; ha is o raise workers reenion raes, morale and produciviy (see Phelps, 1968). In his case he equilibrium unemploymen rae is also deermined by he equaliy of he demand wage (his is he inverse of he price-wage raio) and he supply wage (he one needed o affec worker incenives). When unemploymen is below he naural rae, employers realise ha raising (relaive) wages raises profis by increasing he efficiency of he workforce. In a symmeric equilibrium, hey all end up raising wages hence only raising he real produc wage, which hen forces hem o reduce he workforce. As unemploymen grows, he efficiency of labour rises and he incenive o raise relaive wages falls unil he naural rae of unemploymen is reached wih consan wages and employmen and correc expecaions: unemploymen has become a disciplinary device. In boh of hese formulaions, he equilibrium rae of unemploymen in seady sae he naural rae of unemploymen depends on he level of workers alernaive income ha is heir non-wage income and social suppor and employers opimal 9

13 mark-ups which depend on expeced produciviy growh and real ineres raes, amongs oher facors. II.1 A exbook model In he simples case wih consan reurns o labour, he price-seing curve (labour demand under condiions of imperfec compeiion) can be wrien as ( ) p = w λ + µ C (1) where p and w denoe he log of nominal prices and wages respecively, λ is he log of labour produciviy, C is he level of compeiion in produc markes, and µ is he mark-up of price over marginal coss. Similarly, he wage-seing relaion can be simplified o become equaion (2): ( ) e φ λ w = p u + + z W (2) We le u denoe he unemploymen rae, e p is he expeced level of prices, and z is a vecor of wage-push variables. The vecor capures such facors as union objecives, he frequency of srikes, he generosiy of he welfare sae and he probabiliy of finding a job once unemployed. We le z be a funcion of (naional) wealh because more wealh is likely o increase welfare spending. The probabiliy of finding a job reflecs he rae of urnover in he labour marke how long one can expec o remain unemployed which is closely relaed o he fracion of workers who remain unemployed for longer periods of ime (he long-erm unemployed). Now puing equaion (2) ino (1) we ge equaion (3) ha can be solved for he equilibrium unemploymen rae which is he naural rae of unemploymen. e ( W ) ( C ) p = p φ u + z + µ (3) The price level oday is a posiive funcion of he expeced price level, he level of mark-ups µ, and he wage-push erms in vecor z. Las year s prices maer because hey affec curren wages hrough wage seing which hen affec curren prices hrough price seing (see Péursson, 21). However he level of produciviy λ drops ou as i raises boh he supply- and he demand wage. 6 This represens a reasonable normalisaion because workers alernaive wages in he form of ineres, dividend and ren, can be expeced o rise a he rae of labour produciviy. 6 This is consisen wih a zero rend in unemploymen over long periods of ime despie growing produciviy. 1

14 Seing e p = p, which assumes correc expecaions, gives a soluion for he naural rae of unemploymen: u ( C ) + z ( W ) µ = (4) φ * The naural rae of unemploymen is a posiive funcion of he level of mark-ups, union miliancy, he frequency of srikes and he generosiy of he welfare sae. Produc-marke compeiion and wealh affec he level of he naural rae hrough he level of mark-ups more compeiion reduces he equilibrium level of mark-ups and also by causing welfare spending o go up as he ax base expands which raises unions and workers fall-back level of uiliy and acs o push up wages and raise unemploymen. One can now rewrie equaion (3) as a Phillips curve. Simple algebraic manipulaions yield: e ( W ) ( C ) π = π φu + z + µ (5) Assuming adapive expecaions or raional expecaions when inflaion follows a e random walk gives π = π 1 and he Phillips curve acquires he acceleraionis form: ( W ) ( C ) π = π 1 φu + z + µ (5 ) I follows ha in an expecaional equilibrium when inflaion is neiher rising nor falling unemploymen is a is naural level which is given by equaion (4). II.2 A simple mehod of calculaing he naural rae The key problem in calculaing he level of he naural rae is he fac ha one does no know a priori wha are he elemens of he vecor z in equaion (2) nor can we measure mark-ups accuraely. In oher words, we canno a priori specify which facors influence he naural rae can shif eiher he price- seing or he wage-seing relaionship. For his reason, Elmeskov e al. (1993) assume ha we can omi unknown erms from equaion (5 ) wihou biasing he coefficien of he unemploymen rae unduly, which gives he following empirically esable equaion; π + (6) = α φ u ε where α = µ + z and ε is he error erm. I should be clear ha α does no have o be consan over ime and o he exen ha i does change equaion (6) involves a 11

15 misspecificaion. However, if his does no affec he esimae of φ significanly, we can use he equaion o calculae he naural rae by a simple rule of humb. The naural rae of unemploymen is by definiion he rae of unemploymen where inflaion (be i price- or wage inflaion) is unchanging. We show equaion (6) in he figure below and how i defines he naural rae. Figure 8. Calculaion of he naural rae π α u* u The slope of his relaionship is equal o -φ while he posiion depends on he value of α hence he level of µ and z. The rule of humb for calculaing he naural rae based on equaion (6) is he following: Rule of Thumb for calculaing he naural rae Find he value of φ and use i o calculae how much unemploymen would have o change for π o equal zero given is curren value. More precisely, we calculae he naural rae by seing α = φu * which gives he following equaion; * ( u u ) π = φ (7) ha can be solved for u* once we know he values of φ, u and π : * π + φu u = (8) φ Since he esimae of u* ha is generaed by equaion (8) ends o be very noisy, one usually smoohes he series wih he Hodrick-Presco filer and he smoohed series describes he pah aken by he naural rae of unemploymen. 12

16 II.3 Measuring he naural rae of unemploymen in Iceland In Gudmundsson and Zoega (1997) equaion (6) was esimaed for he period where he rae of change of he labour force was added o he regressors in order o conrol for is effec on unemploymen, for reasons ha will become apparen laer in Secion IV.2, and inflaion was defined as he average rae of change in he GDP deflaor in he wo years ha follow each unemploymen observaion. The resuls follow; Table 7. Esimaion resuls for equaion (7), Parameer Esimae -saisic α φ log(l) R 2 =.65 2 R =.6 We can now look a he empirical performance of hese esimaes by updaing he implied NAIRU and hen reflec on he inflaion experience. Figure 9 below updaes he NAIRU esimaes for (see Gudmundsson and Zoega, 1997). In he pas 12 years, he naural rae racks acual unemploymen o a surprising (one could say alarming) exen. In paricular, i falls afer 1996 wih he general unemploymen rae. Figure 9. Naural-rae esimaes for Iceland 6 % acual unemploymen naural rae

17 In Figure 1 below here is a plo of he discrepancy beween he acual unemploymen rae and he naural rae esimae, on he one hand, and he firs difference of he inflaion rae, on he oher. An obvious negaive relaionship is visible prior o 1989 which hen disappears in he las en years or so. The difference beween acual unemploymen and he naural rae is hus srongly negaively correlaed wih he acceleraion of inflaion up o 199. This includes he 196s (-.57), he 197s (-.79) and he 198s (-.89). Noe ha while he coefficiens were esimaed for he period , he period is ou of sample. However, he correlaion disappears in he 199s (i is only.25 for he years ). I follows ha he model is no erribly useful when predicing inflaion in he 199s. Figure 1. Inflaion and he naural-rae esimaes 1.5 u-naural rae (%) 1. change in inflaion 8 inflaion growh (%) u-naural rae A his poin one needs o address wo quesions. Firs, wha makes he esimaed naural rae of unemploymen rack he acual unemploymen rae so closely? Second, why does he discrepancy beween he acual and he naural rae of unemploymen fail o predic changes in inflaion in he 199s? The derivaion of he naural-rae equaion (8) gives some clues as o where o find an answer. I is clear ha if he elevaion of unemploymen in he firs half of he 199s did no go ogeher wih falling inflaion, and if he fall in unemploymen in he second half of he 199s did no cause rising inflaion, hen he naural rae esimae will follow closely he acual pah aken by unemploymen over his period. This leads o he quesion wheher i is plausible ha he naural rae changed in his manner or wheher oher facors 14

18 prevened inflaion from responding o changes in he unemploymen rae while he naural rae remained a is earlier level. III. Possible reasons for he evolving naural rae in he 199s The quesion now arises wheher he rise and fall of he naural rae shown in Figure 9 can be raced o any of is suspeced deerminans. One has o consider boh hose explanaions ha have been floaed in he lieraure as well as hose ha may be paricularly relevan for Iceland. We sar wih he former. III.1 Explanaions from he unemploymen lieraure The world s unemploymen paerns fall broadly ino hree caegories. Firs, in he U.S. he apparen changes in he naural rae appear small in magniude. There is he gradual upward rend documened by Juhn, Murphy and Topel (1991) and he decline in he pas 5 years. Second, here is he ypical coninenal European paern of wo big elevaions in he mid 197s and he early 198s followed by a parial cyclical recovery in he lae 198s and hen a reurn o high unemploymen in he 199s. Finally, he Scandinavian counries (excluding Denmark which follows he coninenal paern) exhibi consan average unemploymen unil he end of he 198s, hen a significan elevaion followed by he recen recoveries. The economics lieraure on medium erm changes in he U.S. has focused on he naure of echnical progress and demographics. This forms he firs class of poenial culpris: Demographic rends such as changes in he proporion of young workers and he leas educaed. Boh groups ypically have higher wihin-group unemploymen raes. The ageing of he baby-boom populaion in he Unied Saes is one frequenly menioned reason for he curren combinaion of low unemploymen and low inflaion (Phelps and Zoega, 1997, 2; Shimer, 1998). 7 7 A recen paper (Kaz and Krueger, 1999) also emphasizes he rise in he prison populaion bu he share of he prison populaion in he civilian non-insiuional populaion is now approaching one percenage poin. This maers because he individuals affeced are significanly more prone o unemploymen. Kling (1995) found ha he employmen o populaion raio is ypically only 35% for his group. 15

19 Job insecuriy may have reduced wage demands by unions and allowed employers o offer lower wages wihou adverse effecs on moral and effor. Due o corporae resrucuring and re-organisaion, workers can no longer coun on heir jobs as before. This facor would appear in he erm z in he wage-seing equaion (2). Skill-biased echnological change and inernaional rade. Boh may reduce he marginal produc of he leas educaed, raising heir relaive unemploymen raes and reducing heir relaive wages (Krugman, 1994). The idea is ha a fall in he level of produciviy λ in equaions (1) and (2) affecs primarily he demand wage (equaion (1)) and no he supply wage (equaion (2)) for his group because he poores workers rely on welfare benefis raher han oher forms of non-wage income. Presumably welfare spending is no very responsive o changes in produciviy from one year o anoher. None of hese hree explanaions provides a plausible explanaion for he unemploymen pah in Iceland in he 199s. Demographic developmens, biased echnical progress and changes in inernaional rade have been gradual and do no exhibi he cyclical paern seen in he unemploymen variable. While such demographic and echnological changes are given a big role in he lieraure on U.S. unemploymen, sudies of he elevaion of unemploymen in he res of he OECD end o emphasise differen facors. The price of oil. The iming of he 197s hikes in he world real price of oil coincided wih he iming of he elevaion of unemploymen in a grea many of he OECD counries. Models linking oil prices o unemploymen go back o Bruno and Sachs (1986). The idea is ha eiher he marginal produc of labour falls because of a reducion in he use of energy assuming ha he wo facors are complemens in producion or ha higher oil prices cause a rise in he mark-up of price over marginal coss which acs o reduce he real demand wage and hence raise unemploymen. The real price of peroleum in Iceland (ha is he raio of he nominal price and he GDP deflaor) fell in he mid 198s due o developmens in world markes before unemploymen sared is upward ascen. 16

20 Figure 11. Energy prices and unemploymen u n e m p p r ic e o f p e r o l ( p r ic e s ) u n e m p lo y m e n p r i c e o f 9 p e r o l We can for his reason discoun he possibiliy ha changes in energy prices had much o do wih he pah of unemploymen. Non-wage income. Increases boh in he income and services from privae asses and in benefis from social enilemens relaive o afer-ax wage and from he growh of he welfare sae in he 196s and 197s should affec he supply wage hrough he erm z in he equaions above. Social benefis and privae non-wage income income from wealh make labour more expensive since unions can demand and employers may offer higher wages in ligh of he improved fallback opions of workers. In Spain and Ialy an imporan componen of non-wage income is family suppor. 8 This effec is again capured by he erm z in he wageseing equaion (2). The ime pah of welfare spending as a proporion of GDP rends upwards in Iceland from 196 unil he lae 198s and hen levels off before unemploymen sars is upward move. 8 Despie very high unemploymen raes, he household unemploymen rae defined as he fracion of households wihou any income earner is close o he OECD average suggesing ha he family may be he real welfare sae. 17

21 Figure 12. Welfare spending (% of GDP) and unemploymen w e lf a r e s p e n d in g ( % ) u n e m p. ( % ) u n e m p lo y m e n w e lf a r e s p e n d in g If anyhing, unemploymen and welfare spending end o be inversely relaed in Figure 12; when welfare spending rises, unemploymen falls. Insiuions. A model by Layard, Jackman and Nickell (1991) poined o new or expanded insiuions in he pos-war era, especially in Europe, such as unemploymen insurance benefis and job proecion, which heighened he sensiiviy of unemploymen o shocks. This represens a culminaion of work on he impac of he unemploymen insurance sysem boh replacemen raios and he duraion of benefis he organisaion of labour unions such as heir cenralisaion as poined ou by Calmfors and Driffill (1988) and he exen of union densiy and coverage. This work has much influenced hinking a he OECD where insiuional reforms were he backbone of policy recommendaions in is Jobs Sudy (OECD, 1994). Once again, his effec is found in he erm z in our model of Secion II. The evoluion of labour-marke insiuions in Iceland does no fi he unemploymen pah. No fundamenal changes in he organisaion of labour unions or he unemploymen-benefi sysem preceded he rise in unemploymen. The cos of capial. There is he OECD-wide increases in he effecive cos of capial resuling from expecaions of lower produciviy growh emerging in he 197s and he increased expeced world real rae of ineres emerging in he early 18

22 198s. Boh developmens may reduce invesmen in human capial, mos imporanly he raining aking place in firms and employmen conracs as a resul. In he model of Secion II, a higher cos of capial may cause firms o raise mark-ups ha is inves less in an expanding marke share hence reduce he demand wage, which hen causes unemploymen o go up. 9 As shown in Figure 13 below, changes in real ineres raes in he 199s do no mirror changes in unemploymen because ineres raes remained high hroughou he decade having risen in he lae 198s while unemploymen rose in he firs half of he decade and fell in he second half. However, developmens in capial markes were sufficienly imporan o warran a separae Secion IV.2 below. The lieraure on Scandinavian unemploymen (i.e. Honkapohja, 1999) has pu more weigh on cyclical facors. In paricular, financial crises, corporae deb and high real ineres raes are presumed o have reduced aggregae demand causing a cyclical downurn. The high real ineres raes in Iceland during he 199s may have had such a cyclical effec on oupu and employmen. 1 IV.2 The local scenery Secion I described labour-marke daa during he bus of he firs half of he 199s and he boom of he second half of he decade. We now ake a look a some of he shocks ha may have affeced he evoluion of unemploymen over his period. Macroeconomic shocks Capial markes were liberaed gradually in Iceland during he 198s. The mos significan consequence of hese reforms for our purposes was he rise in real ineres raes and he lessening of capial raioning. Figure 13 shows he unemploymen rae superimposed on wo measures of real ineres raes: he ex-pos real rae of ineres on non-indexed bank loans and he rae of ineres on indexed bank loans. 9 A formal model yielding his resul is he cusomer-marke model of Phelps and Winer (197). In his model, he firm s mark-up decision is an iner-emporal invesmen decision: by reducing mark-ups he firm invess in an expanded marke share in he fuure and by raising mark-ups i raises curren profis a he expense of a lower fuure marke share. I follows ha a higher cos of capial would end o reduce invesmen, hence cause firms o raise heir mark-ups, which hen acs o increase unemploymen in our model. 1 In he Scandinavian lieraure, i should be noed, here is also a srand of hinking ha emphasises 19

23 Figure 13. Unemploymen and he real rae of ineres 2 6 u n e m p. % 5 4 r e a l in e r e s r a e s r e a l in e r e s r a e s o n in d e x e d b a n k lo a n s in.ra e s 1 % u n e m p lo y m e n The real-ineres-rae series undergo a regime shif in he middle of he 198s following he liberalisaion of capial-markes. The real rae of ineres on nonindexed bank loans jumps by more han 2% ha is 2 basis poins! The corresponding rise in he rae of ineres on indexed bank loans is over 5 basis poins. The shif in he ineres-rae regime precedes he rise in unemploymen in he early 199s ha sared in However, his does no lend much suppor o he pure ineres rae hesis above because he fall in unemploymen in he las five years coincides wih record high ineres raes. The liberalisaion of capial markes and he rise in real ineres raes brough abou a ransformaion of he Icelandic economy. In conras o he earlier period of negaive required raes of reurn facing owners of producive capial, he pos-liberalisaion era had required raes of reurn in excess of 1%. The consequences of his regime shif were no unexpeced; he number of bankrupcies increased drasically as shown in Figure 14. he srucural or real facors behind he unemploymen experience (see Lindbeck, 1997). 2

24 Figure 14. The number of bankrupcies u n e m p l. % n u m b e r o f b a n k r u p c i e s u n e m p l o y m e n b a n k r Ineresingly, he plo showing he number of bankrupcies resembles he ime pah of unemploymen and also he ime pah of he share of capial in naional income. I follows ha he number of bankrupcies and labour s share in naional income are inversely relaed as shown in Figure 15. Taken ogeher, Figures sugges ha he rise in he cos of capial in he mid- o laer 198s caused he share of labour o fall which hen aced o raise he unemploymen rae. This poins owards shifs in labour demand as he key culpri in he rise and fall of unemploymen in he 199s. Figure 15. Bankrupcies and labour s share in naional income b a n k r. l a b o u r ' s s h a r e p r o fi s h a r e % n u m b e r o f b a n k r u p c i e s Figure 16 has he number of vacancies repored in he biannual survey by he Naional Economic Insiue (also shown in Figure 1) spring and auumn observaions each represened by is own plo alongside he number of bankrupcies for each year. Noe ha he scale measuring vacancies has been invered o draw aenion o he close associaion beween he wo variables. The negaive relaionship beween he number of vacancies and he number of bankrupcies provides anoher 21

25 piece of evidence suggesing ha labour demand fell in he firs half of he decade and hen recovered. Figure 16. Bankrupcies and vacancies b a n k r. 5 v a c a n c ie s i n S e p. / O c. v a c a n c ie s in A p r il -2 v a c a n c ie s b a n k r u p c ie s Finally, he associaion beween he number of bankrupcies and he growh of real (consumpion) wages provides a furher proof for he role of labour-demand shifs in he unemploymen saga of he 199s. Figure 17. Bankrupcies and real wages % b a n k r u p c ie s r e a l w a g e g r o w h b a n k r Real-wage growh falls when he number of bankrupcies is rising and picks up again when he number of bankrupcies levels off. Unemploymen resuling from reduced incenives o work Figures 6 and 7 showed ha he rae of unemploymen and he capial share have moved ogeher in Iceland, which yields a negaive relaionship beween 22

26 unemploymen and he share of labour in naional income. A simulaneous fall in boh he labour share and employmen is a clear sign of an adverse labour-demand shock. Similarly, when labour demand recovers, his resuls in an increase in he labour share and a fall in unemploymen. We can hen exclude shifs in wages demanded i.e. changes in union aciviy from he lis of possible culpris. A fall in labour demand can cause rising unemploymen in he presence of realwage rigidiy caused by eiher unions or efficiency-wage consideraions as described in equaion (2). However, even in he absence of such rigidiies, unemploymen can increase if here are fixed coss of having a job and/or unemploymen benefis. In Iceland his becomes more likely because, as an empirical maer, he lowes wages fall disproporionaely in recessions and rise disproporionaely in recoveries. Figure 18 below shows ha he share of he lowes percenile of workers in oal earned income, on he one hand, and unemploymen, on he oher hand, are srongly correlaed: when he share of he lowes-paid workers falls, unemploymen ends o rise. Figure 18. The share of he lowes percenile of workers in earned income and unemploymen s h a r e ( % ) s h a r e o f lo w e s p e r c e n ile u n e m p lo y m e n u n e m p l o y m e n (% ) A relaed paern comes hrough in Figure 19 where he evoluion of inequaliy (in erms of earnings) measured by a Gini coefficien is superimposed on he unemploymen rae The Gini coefficiens are calculaed for all axpayers, independen of employmen saus, bu he same paern emerges when only employed workers are included in he sample. 23

27 Figure 19. Inequaliy and unemploymen u n em p lo y m e n.44 (% ) 6 G in i c o e f fic ie n.43 5 G in i u n e m p lo y m e n Source: Naional Economic Insiue and Finnur Geirsson (1977). The rise in inequaliy in he lae 196s coincided wih a rise in unemploymen. The same applies o he minor recession in 1983 and, more imporanly, he susained rise in unemploymen saring in Finally, he las upswing saring in 1996 hen makes he earnings disribuion more compressed. Figure 2 shows changes in unemploymen raes by educaion. I is clear ha he boom group suffered disproporionaely in he slump of he firs half of he 199s. I is no uncommon o observe higher unemploymen raes among he less educaed. In fac, his is he paern in mos OECD counries. Wha is ineresing in he case of Iceland is, however, ha unemploymen raes of universiy graduaes and workers wih vocaional raining did no a all share he same paern as he naional average in he 199s: hese raes did no rise in he firs half of he 199s and fall in he second half of he decade. One has o move down o workers whose erminal degree is from secondary school o see he pah of unemploymen rising in he firs half of he decade and falling in he second half. However, he numbers end o be low for his group: he maximum unemploymen rae reached in 1995 is only 4%. In conras, when one looks a he unemploymen raes of workers whose erminal degree is from primary school, he picure changes and we observe a srong cycle in he 199s he rae of unemploymen rising from 4.1% in 1991 o 8.6% in 1994 and hen falling back o 3.8% in

28 Figure 2. Unemploymen raes by educaion 1 8 Mandaory educaion (11 years) 6 4 Secondary school 2 Vocaional Universiy degree Source: Hagsofa Islands. Consequenly, he relaive unemploymen rae of he leas educaed rose in he firs half of he decade if we measure i by he difference beween he wihin-group rae and average unemploymen. Daa on unemploymen by family saus is even more revealing. Table 1 has he rae of unemploymen for women classified on he basis of heir family circumsances. Noice ha while childless women do beer han he average, mohers do worse. This effec is srong for women wih wo or more dependen children, especially hose who care for a child younger han six years of age. Boh he absolue and he relaive unemploymen rae of women wih wo children moves wih he average unemploymen rae: when he rae of unemploymen is high, relaive unemploymen is high among hose wih wo children. The numbers in his able suggess ha he reason why unemploymen rose in response o falling labour demand during he firs half of he 199s and hen recovered in he second half lies no so much in he inflexibiliy of real wages described by he wage-seing equaion (2) above as in a reduced incenive o remain acively in he labour marke. When wages fall a he boom end of he wage disribuion, one finds ha he unemploymen rae of workers who have a high fixed cos of employmen goes up. The fixed cos of childcare is considerable in Iceland. When we sum up he unemploymen benefis and he cos of childcare for women wih wo young children, we find ha he incenive o hold a low-paying job is almos non-exisen. However, when wages sar rising, he incenive o find a job is increased and he unemploymen rae falls. 25

29 Noe ha he rise and subsequen fall in unemploymen among women who do no have children is minuscule. Their unemploymen rae sared ou a 1.6% in 1991 and peaked a 2.8% in 1995 and hen fell o 1.8% in Wha disinguishes he wo groups of women hose wih children and hose wihou is primarily he cos of childcare plus any non-pecuniary benefi from saying a home. Table 1. Unemploymen raes for women aged 25-54, by family saus Year Average, all women No children Children child years years or more children Younges Younges Source: Hagsofa Islands The paern revealed in Figure 2 suggess he same explanaion for he unemploymen swings. When labour demand falls, which causes wages o go down, he unemploymen raes of he leas educaed rise while hose for workers wih vocaional and universiy raining are hardly affeced a all. Differences in wages across educaion levels sugges ha he reason for he greaer rise in unemploymen among he leas educaed may be parly heir low iniial wages, which hen fall below he reservaion levels for coninued employmen. Falling wages a he boom of he wage disribuion may be o blame for increased joblessness. This may explain parly why wage- and price inflaion did no respond o changes in he measured unemploymen rae for a long ime, no unil he las wo years or so. The fall in labour demand has caused he effecive labour force o shrink and job losers do no exer significan pressures on wage- and price behaviour. There is also anoher reason why he labour force has changed over he period. This has o do wih he flow of foreign migran workers o he counry. 26

30 Migran workers Recen economic condiions in Iceland dicae ha we pay special aenion o he presence of foreign migran workers who mee excess demand in cerain indusries iniially in he fish-processing indusry bu now also in he consrucion and service indusries who leave he counry as soon as his excess demand ceases. This is a one-way sream of workers because he rae of emigraion by Icelandic workers in response o economic downurns is small in comparison o cyclical changes in employmen. 12 Figure 21. Emigraion (raio o labour force) and he unemploymen rae 6 % 5 4 u n e m p l o y m e n e m i g r a i o n We noe he sudden emigraion in response o rising unemploymen in he lae 196s. Apar from his, here is an upward rend in emigraion from he mid 198s o he mid 199s and hen a reversal of his rend. A similar paern is visible in Figure 21, which has immigraion as a raio o he labour force. 12 See Agnarsson e al. (1998). 27

31 Figure 21. Immigraion (raio o labour force) and he unemploymen rae 6 % 5 4 u n e m p l o y m e n i m m i g r a i o n Finally, we plo he ne in-migraion (immigraion ne of emigraion) as a raio o he labour force agains he unemploymen rae in Figure 22. The wo series are negaively correlaed. When unemploymen rises, he ne rae of immigraion falls and vice versa. Figure 22. Ne immigraion (raio o labour force) and he unemploymen rae % u n e m p l o y m e n n e i m m i g r a i o n A fundamenal change in he ideniy of immigrans occurred in he lae 199s. Insead of Icelanders reurning home, we can see a rise in he number of foreign workers, many from Easern Europe, who come as emporary workers o mee excess demand for labour in he fishing indusry, and more recenly in consrucion and services. In his way he immigrans preven wage pressure from building up in seleced bolenecks and he economy as a whole. I is likely ha he influx of foreign labour has prevened wages from rising in recen years more han we have observed in he daa. The basic model can be modified o ake ino accoun (ne)immigraion. In 28

32 equaion (2 ) we have added he rae of (in)migraion L & L o he wage-seing schedule, while leaving he price-seing schedule unchanged. The idea is ha when he value of L & L is high, more workers will be looking for a job han oherwise. This makes unions fear job losses among heir members because hey realise ha any unemployed union worker would face siff compeiion for jobs. The unions are likely o ask for lower wages as a resul. The same happens when firms se wages in he absence of unions. They se lower wages realising ha a job loss would have significan effecs on he workers involved because i is more difficul o find a job wih foreign labour compeing for vacancies. ( C ) p = w λ + µ (1 ) e L& w = p φ u + γ + z L + λ ( W ) The parameer γ in equaion (2 ) measures how subsiuable foreign labour is in relaion o domesic naionals. If hey are equal in every sense, he coefficiens γ should be equal o one. I follows ha an increase in he rae of flow of foreigners ino he domesic labour marke allows firms o se lower wages and induces unions o reduce heir wage demands, hence expanding domesic employmen. The naural rae of unemploymen falls, which implies ha lower raes of unemploymen are now compaible wih price sabiliy. We have shown ha he one-o-one relaionship beween unemploymen and inflaion is disruped by changes in he labour force over he business cycle. When he economy is booming, he lowes wages are pushed up bringing in workers who face a combinaion of low wages and fixed coss of employmen and also especially in recen years immigran workers. The process is hen reversed when a recession ses in. These changes in he effecive labour force weaken he relaionship beween unemploymen and inflaion. A low raes of unemploymen, inflaion does no rise as expeced because firms are filling vacancies wih workers who are jus enering he labour marke. And a high unemploymen raes, he downward pressure on wages and prices is miigaed by he effecive wihdrawal of many low-income workers from he labour marke as well as he deparure of foreign workers. Equaion (3) will now read (2 ) 29

33 e L& p = p φ u + γ z + µ L + ( W ) ( C ) which gives he following as he definiion of he naural rae of unemploymen (when e p = p ): u ** µ = ( C ) + z ( W ) φ L& γ L The equaion implies ha he naural rae is pushed down when he labour force is growing because workers face increased compeiion for jobs and his makes hem reduce heir wage demands. In a period when workers leave he labour marke, he naural rae is pushed up for he same reason. Unions realise ha heir members face limied compeiion and ha hey can hence be more aggressive in heir wage demands. Noe from Figure 22 ha he range of magniudes of he rae of growh of he labour force due o ne immigraion is plus o minus 1%. The effec on he naural rae is hen in he same range if γ=1. From Table 7 above one can infer ha he value of γ is around ½, which reduces he maximum effec of migraion o plus o minus ½%. Add o his he effec of enry/exi of low-skilled workers and one can ge a sizeable effec on he esimaed naural rae. There is also anoher reason why he esimaed naural rae pah may follow he pah of acual unemploymen in some insances. If i is more difficul o make inflaion fall when i is already low han when i sars ou being high, here arises an asymmery in he inflaion dynamics, in paricular he relaionship beween inflaion and unemploymen. This is he focus of he following secion. (3 ) (4 ) IV. The Srucural sabiliy of he Phillips curves In ligh of he close correspondence beween he esimaed naural rae of unemploymen and acual unemploymen in Secion III and he lack of predicive power of he naural- rae esimae, we now ake a closer look a he underlying daa and relaionships. III.1 Tesing for srucural insabiliy The figures below show scaer diagrams for he acceleraionis Phillips curve. Figure 23 has he price-phillips curve and Figure 24 he wage-phillips curve. The former has he change in he rae of price inflaion, measured by he GDP deflaor on he verical 3

34 axis and he unemploymen rae on he horizonal axis. Inflaion is measured as he average rae of inflaion in he wo years ha follow each unemploymen observaion and he inflaion difference is equal o he difference beween is curren value and is lagged value wo years back. We firs show he relaionship for he period and hen for he whole period Figure 23. Phillips curve using he GDP deflaor Average change in inflaion in nex wo years (percenage poins) Average change in inflaion in nex wo years (percenage poins) Unemploymen rae (percen) Unemploymen rae (percen) There appears o be a relaionship in he firs period as shown in he lef-hand char. The figure also has he leas-squared line fi hrough he observaions for hese years. The bigges oulier is in 1983 where he rae of disinflaion was around 5% a only 1% unemploymen. When one plos he wo variables in a scaer diagram for he whole period he relaionship disappears. I is blurred by he observaions from he 199s where high unemploymen goes hand in hand wih approximaely consan inflaion and also by observaions from he 196s where boh rising and falling inflaion occurs a very low unemploymen raes less han 1 percen for mos years. Now urn o he wage-phillips curve ploed on a scaer diagram where he verical axis has he difference beween wage inflaion and lagged price inflaion (measured by he CPI) and he horizonal axis has he unemploymen rae as before. 31